BMO Financial Corp. Mid-Cycle Dodd-Frank Act Stress Test Severely Adverse Scenario Results Disclosure October 22,
Overview BMO Financial Corp. (BFC), a U.S. Intermediate Holding Company (IHC), is a wholly-owned subsidiary of Bank of Montreal (BMO) and is regulated by the Board of Governors of the Federal Reserve System (FRB or "the Fed"). BFC is subject to the Supervisory and Company-Run Stress Test Requirements for Covered Companies 1 rule issued by the FRB to implement the stress test requirements established in section 165(i)(1) and (2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). 2 The Dodd-Frank Act company-run mid-cycle stress test results presented in this report estimate the impact of a hypothetical severely adverse macroeconomic scenario (Severely Adverse scenario) selected by BFC on its capital position over a nine-quarter forecast horizon. The Severely Adverse scenario is described in additional detail below. BFC performed its internal stress tests using its own models, practices, methodologies and assumptions to project pre-provision net revenue, provisions, losses and capital ratios under the Severely Adverse scenario except in those cases where practices, methodologies and assumptions were specifically prescribed by rules, instructions or guidance published by the FRB. 3 In addition, bank holding companies and IHCs are required to assume a uniform set of conditions regarding capital actions over the forecast horizon to enable comparison of results across institutions and neutralize the effect of company-specific assumptions regarding capital actions. Under this requirement, BFC must calculate its pro forma capital ratios using the following factors and assumptions regarding its capital actions over the forecast horizon for the Severely Adverse scenario: 1. For the initial quarter of the forecast horizon (Q3 ), take into account actual capital actions taken throughout the quarter; 2. For each of the subsequent quarters ( through Q3 ), include in the projection of capital: i. Common stock dividends equal to the quarterly average dollar amount of common stock dividends that the company paid in the previous year (i.e., the initial quarter of the forecast horizon and the preceding three calendar quarters); ii. Payments on any other instrument that is eligible for inclusion in the numerator of a regulatory capital ratio equal to the stated dividend, interest or principal due on such instrument during the quarter; iii. An assumption of no redemption or repurchase of any capital instrument that is eligible for inclusion in the numerator of a regulatory capital ratio; and iv. An assumption of no issuances of common stock or preferred stock, except for issuances related to expensed employee compensation or in connection with a planned merger or acquisition. 1 'Supervisory and Company-Run Stress Test Requirements for Covered Companies Final Rule, 12 C.F.R Part 252. 2 The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), enacted on May 24,, amends provisions in the Dodd-Frank Act, including bank holding company asset thresholds upon which stress testing requirements are based. EGRRCPA's ultimate impact on stress testing requirements applicable to BFC will depend on how the Act is implemented by the FRB. 3 'Dodd-Frank Act Mid-Cycle Stress Tests 2013 Summary Instructions' published by FRB on May 13, 2013. BMO Financial Corp. 1
In actual practice, if a severely adverse scenario were to occur, BFC would take capital and other management actions mandated by its internal policies and which are necessary or appropriate to respond to such stress. BFC is well-capitalized with a strong, pre-stress actual Basel III Common Equity Tier 1 (CET1) ratio of 11.8% as of June 30,, and has sufficient capital to withstand the consequences of severe stress. As depicted by the results of the Severely Adverse scenario presented below, BFC maintains strong capital levels, with a minimum CET1 ratio of 10.6% over the forecast horizon, which is considerably higher than the applicable Basel III regulatory well-capitalized requirement of 6.5% and minimum value of 4.5%. BFC maintains pro forma regulatory capital ratios that are higher than the regulatory minimums throughout the forecast horizon, despite reduced pre-provision net revenue and higher losses. Severely Adverse Scenario Scenario Overview The Severely Adverse scenario is characterized by a dramatic shift in investor risk appetite catalyzed by the Federal Reserve s balance sheet normalization program and a widening budget deficit. Rising long term yields cause a broad sell-off in bonds that results in a sharp increase in pricing for consumer and commercial lending. Households are severely stressed by variable rate products and corporate lending activity slows. The shock to the household sector results in a decline in housing prices which in turn leads to a cycle of wealth erosion and asset price depreciation, while capital investment drops. The U.S. economy experiences a rapid retrenchment that sees real GDP decline by 5.4% over six quarters. Unemployment peaks at 9.4% and recovers slowly as sustained asset price weakness tempers the pace of the ensuing economic recovery. Housing prices decline by 28% as measured by CSI over the span of 12 quarters, while equities fall more than 50% by the end of the scenario. High yield corporate bond markets are negatively impacted, with the 10-year BBB corporate bond spread peaking at 760 bps and benchmark yields also sharply higher. Regionally, the U.S. Midwest sees greater declines in real GDP and higher unemployment rates given less favorable demographic trends and business conditions at the onset of the recession. Home prices in the region experience more pronounced downturns than the national average as speculative investments suffer significant losses. The charts below provide a view of the path specific U.S. macroeconomic variables, which are drivers of the estimation process, follow through the forecast horizon. U.S. Real GDP U.S. Unemployment Rate 17,800 17,600 17,400 17,200 17,000 16,800 16,600 16,400 10% 9% 8% 7% 6% 5% 4% 3% BMO Financial Corp. 2
Case-Shiller House Price Index West Texas Intermediate Prices 210 200 190 180 170 160 150 140 80 70 60 50 40 30 20 10-Year Treasury Yields S&P 500 Index 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 3,600 3,000 2,400 1,800 1,200 600 Corporate Risk Spread, A-Rated Corporate Risk Spread, BBB-Rated 6% 5% 4% 3% 2% 1% 0% 9% 8% 7% 6% 5% 4% 3% 2% 1% BMO Financial Corp. 3
Severely Adverse Scenario Estimates BFC maintains strong regulatory capital ratios throughout the forecast horizon from Q3 through Q3. The minimum and ending values are depicted below. Also shown below are risk-weighted asset projections as well as loan loss and income statement forecasts throughout the scenario. BFC projected stressed capital ratios through Q3 Ratio Actual Stressed Capital Ratios 1 Ending Minimum Common Equity Tier 1 capital ratio 11.8% 10.8% 10.6% Tier 1 risk-based capital ratio 12.4% 11.5% 11.3% Total risk-based capital ratio 15.0% 14.7% 14.5% Tier 1 Leverage ratio 9.9% 8.8% 8.8% 1 The pro forma stressed capital ratios are calculated using DFAST capital actions and assumptions as described above. These projections represent hypothetical estimates under severely adverse economic conditions specified in the Severely Adverse scenario. The minimum capital ratios presented are for the period Q3 through Q3. BFC actual and projected Q3 risk-weighted assets Billions of dollars Actual Projected Q3 BFC Risk-Weighted Assets 106.1 94.6 As depicted in the chart below, the change in capital ratios from actual levels to the minimums through the forecast horizon in the hypothetical Severely Adverse scenario primarily reflects the impact of higher provisions for credit losses (PCL). This impact is partly offset by pre-provision net revenue (PPNR) generated over the forecast horizon as well as lower risk-weighted asset (RWA) levels. Key Drivers of BFC's Pro Forma Common Equity Tier 1 Capital Ratio 14.0% 12.0% 11.8% 1.0% 1.2% 10.8% 10.0% 0.2% 8.0% (3.3)% (0.1)% 6.0% 4.0% 2.0% 0.0% PPNR PCL Dividends Other Changes to Capital ¹ Decrease in RWA Q3 1 Other changes to capital include changes in disallowed intangibles net of related deferred tax liabilities, net change in deferred tax assets in disallowance as well as other miscellaneous adjustments. BMO Financial Corp. 4
BFC projected loan losses, by type of loan, from Q3 through Q3 Loan Type Billions of dollars Portfolio loss rates (%) 1 Total Loan Losses 2.9 3.9% First-lien mortgages 0.2 2.0% Junior liens and HELOCs 0.1 3.1% Commercial and industrial 1.4 4.9% Commercial real estate 2 0.6 5.4% Credit cards 0.1 17.6% Other consumer 0.1 2.8% Other Loans 0.4 2.3% 1 Average loan balances used to calculate portfolio loss rates exclude loans held for sale and are calculated over nine quarters. 2 Commercial real estate loans include loans secured by farmland. BFC projected losses, revenue, and net income before taxes from Q3 through Q3 Item Billions of dollars Percentage of average assets Pre-provision net revenue 1 1.1 0.8% Other revenue % Less Provisions 3.4 2.6% Realized losses/(gains) on securities (AFS/HTM) 0.0 0.0% Trading and counterparty losses/(gains) 0.0 0.0% Other losses/(gains) % Equals Net income/(loss) before taxes (2.4) (2.6)% 1 Pre-provision net revenue is comprised of revenues less expenses, including mortgage repurchase expenses and other real estate owned (OREO) costs, as well as losses from operational risk events. Material Risks Captured in the Stress Test BFC's Capital Adequacy Process (CAP) is grounded in the processes used to identify, understand and ultimately manage the risks arising from its business model and strategies. As part of BFC's CAP, a broad spectrum of risks are evaluated and stressed, including credit and counterparty risk, market risk, operational risk and other applicable risks; these risks are described below. Credit and Counterparty Risk: Credit and counterparty risk is the potential for loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan or honor another predetermined financial obligation. Credit and counterparty risk underlies every lending activity that BFC enters into, and also arises in the transacting of trading and other capital markets products and the holding of investment securities. Market Risk: Market risk is the potential for adverse changes in the value of assets and liabilities resulting from changes in market variables such as interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, and credit spreads, and includes the risk of credit migration and default in our trading book. BFC incurs market risk in its trading and underwriting activities and structural banking activities. Operational Risk: Operational risk is the potential for loss resulting from inadequate or failed internal processes or systems, human interactions or external events. BMO Financial Corp. 5
Other Risks: Other material risk types evaluated under the CAP and captured in the stress test include liquidity and funding risk, model risk, business risk, environmental and social risk, reputation risk and strategic risk. Many of BFC's material risks, including credit, market and operational risk, are driven by or correlated with changing macroeconomic conditions, and thus are stressed under the Severely Adverse scenario using the methodologies described below. Stress Testing Methodologies BFC's stress testing methodologies are focused on defining the relationship between macroeconomic variables and business volumes, revenues and losses in order to develop pro forma financial statements and estimate the impact on capital availability. Key outputs from these processes are pro forma balance sheets and income statements, which are used to develop risk-weighted assets, average assets for leverage purposes and capital projections in order to estimate stressed regulatory capital ratios. BFC uses models, quantitative and qualitative methodologies, and management judgment, where applicable, to produce a comprehensive projection of business performance under a hypothetical severe stress scenario. All projected results are reviewed and challenged by teams of BFC subject matter experts, and senior crossfunctional and multi-disciplinary management committees, as well as by the Capital Committee of the BFC Board of Directors. The specific methodologies employed are described below. Credit and Other Losses BFC's loss estimation processes are supported by well-established risk measurement frameworks and complemented by robust governance, including independent model validation and effective challenge by business and risk management professionals. Results are benchmarked against key internal and external metrics of performance. Specific to credit risk, loss estimation for each scenario is forecasted by Probability of Default (PD) and Loss Given Default (LGD) stress models that are driven by scenario-specific inputs, exposure and borrower attributes, and balance information. Commercial and Consumer net charge-offs are primarily estimated using quantitative models that forecast stress PD, stress LGD and exposure at default, as well as credit quality changes within the performing portfolios. Commercial and Consumer models are calibrated to BFC's historical loss experience and use risk characteristics of loan segments and exposures to derive results under the Severely Adverse scenario. Operational losses are estimated using a combination of legal and non-legal loss modeling and companyspecific events. The legal modeled losses use legal loss drivers and historical legal settlements, fees and reserves to assess increased losses during stress. The non-legal modeled losses use macroeconomic regression and historical losses to assess increased operational losses during stress periods. Additionally, company-specific events are added to further stress material risks not sufficiently stressed through the models. Trading losses are estimated using market risk stress testing models. Other than temporary impairment on securities and equity investments is estimated at an individual investment level, as applicable. Pre-Provision Net Revenue BFC uses quantitative and qualitative methodologies based on applicable macroeconomic variables to estimate net interest income, non-interest revenue and non-interest expense. Net interest income components are estimated using the projected balance sheet, non-performing loan migration and noncontractual net interest income. Non-interest revenue and non-interest expense are estimated utilizing BMO Financial Corp. 6
historical experience, expert judgment and quantitative approaches. While a majority of the categories are quantitatively modeled, certain categories are judgmentally derived. Provision for Loan and Lease Losses BFC utilizes the loss estimates and credit quality changes forecasted by its methodologies along with a well-established qualitative general reserve framework to quantify the allowance for loan and lease losses. The provisions for loan and lease losses are appropriately estimated to absorb quarterly losses through the forecast horizon and beyond. Capital Position The impact of estimated pre-provision net revenue and losses, changes in asset levels, permitted capital and other management actions and changes in risk-weighted assets are used to estimate BFC's capital position. Risk-weighted assets, average assets for leverage purposes and regulatory capital are calculated throughout the forecast horizon based on the Basel III methodology for non-advanced approaches institutions. The Mid-Cycle Dodd-Frank Act company-run stress test results presented in this report (Stress Test Results) have been prepared in accordance with U.S. GAAP. The Stress Test Results present certain projected financial measures for BFC under the hypothetical economic and market scenario and assumptions designed by BFC. The Stress Test Results are not forecasts of actual financial results for BFC. Investors in securities issued by Bank of Montreal and its affiliates should not rely on the Stress Test Results as being indicative of expected future results. BMO Financial Corp. 7